Building Your Wealth: What You Need To Know Before Investing In ETFs

For most Canadians, mutual funds are still the mainstay of their investment portfolios. However, many investors are angry and frustrated with the high fees that are being charged on mutual funds that rarely match let alone outperform the market. Investing in ETFs seems like a good alternative.

In some respects, ETFs are similar to mutual funds. They are a basket of investments bundled by a financial institution for sale to the investor. The essential distinction of ETFs is that they are a tied to a specific index or a sub-index.

Your returns equal whatever the index gains or loses, minus a small fee.

The big question we are often asked is whether to switch out of mutual funds into exchange-traded funds.

Benefits of Investing in ETFs

The benefits of investing in ETFs are:

• low fees which typically range between 0.05% and 1%, as opposed to costs of up to 3% or more for equity mutual funds,
• diversification,
• accessibility – you can buy and sell at any time throughout the day, and the price is constantly updated which makes them more flexible than mutual funds which are bought and sold at the end of the trading day,
• transparency – holdings are posted online and updated daily,
• no minimum investment
• lower taxable capital gains – only minor changes are made to reflect changes in the index

Buying ETFs

Although a few investment advisors will purchase ETFs for your portfolio if asked, generally you are on your own when it comes to researching, evaluating and buying them.

1. First you have to set up a brokerage account. You can do this with the bank you usually deal with, but if you want to make regular monthly purchases this will also be the most expensive option. Trading fees will quickly outweigh any reduction in MERs. Instead, look for an online brokerage such as Scotia iTrade (limited number) or Questrade (commission-free to buy, but not to sell). Make sure your brokerage account fits your investing needs and be aware of the minimum balance requirements to avoid annual fees.
2. Transfer money into the account. Once all the paperwork is submitted and your account is open, you have to put some money in to it. You can use an electronic fund transfer from your bank account, or fill out the necessary forms to have your existing funds (such as from your redeemed mutual funds) transferred.
3. Decide what to buy. There are now more than 600 ETFs to choose from and you need to be willing to take the time and effort to do the work to find the right mix for your risk tolerance. There are lots of great resources that can help you choose, including the famous Couch Potato blog and some great information from Canadian Portfolio Manager.
4. Find the stock sticker symbol. On the purchase page, insert your stock symbol and the exchange on which it’s trading. For funds trading on the Canadian exchange, for example, some brokerages use “TSX,” and with others you need to add “.TO” after the ticker.
5. Get the price. Look for “get quote” and calculate how many shares you can buy with the money you have. This is a bit different from buying mutual funds because you don’t buy partial shares. So, if you have $1,000 to invest and your fund costs $23.68 you can buy 42 shares (42.229 rounded down). Don’t forget to have enough cash to cover the trading commission, if any.
6. Buy your fund.

Managed ETFs

Most investors will be successful with a portfolio of two to four core funds – a broad Canadian bond fund, Canadian equities, U.S. stocks and international stocks. Regular contributions and rebalancing once a year or so is an effective, easy to manage strategy.

This isn’t sufficiently diverse for many investors. ETFs can target a very specific subset of the index such as REITs, emerging markets, dividend aristocrats, small-cap stocks, global water and infrastructure. Some have other features such as equal weighting of stocks rather than market capitalization, or focusing on value stocks or dividend payers only.

• Tax efficient Total Return Swap lets investors defer tax on dividends until they sell their units, at which point they are taxed as capital gains. These appeal to those using taxable accounts as long as they don’t need to generate dividend income.

e.g. Horizons S&P/TSX 60 (HXT) and Horizons S&P 500 (HXS).

Dividends from U.S. stocks are fully taxable, so deferring them and realizing a capital gain instead can give you significant savings.

• iShares Canadian Fundamental Index (CRQ) uses a unique indexing strategy that puts more emphasis on undervalued Canadian stocks.

Currency Hedging

Currency futures are used to reduce currency risk. A rise in the Canadian dollar will cause U.S. holdings to fall in value. Currency hedging makes more sense if you have a short time horizon, such as less than three years. Most international ETFs use this strategy.

And speaking of international ETFs, some (e.g. Vanguard, iShares) simply hold the U.S.-listed ETF rather than buying the underlying stocks directly. This results in an extra layer of foreign withholding taxes on the dividends. One exception is BMO MSCI EAFE Hedged to Canadian $ (ZDM) which holds the stocks directly – more tax efficient, but has a higher MER.

Fund providers continue to add new offerings all the time. Just in September alone, more than twenty new funds were introduced including such esoteric funds as:

• Horizons Robotics and Automation (ROBO)
• Evolve Gender Diversity (HERS)
• First Asset Tech Giants (TXF.B)

Be aware that all these managed ETFs do have some additional risk plus the fees are a bit higher. Know what the fund’s underlying assets are. Too many asset classes also means additional costs. Funds are already diversified, so don’t slice your pie too thin. You probably won’t get much, if any extra return.

Final thoughts

ETFs started out as a way for investors to tap into the returns of major stock markets using a nice convenient low-cost package that trades like a stock. They are becoming increasingly popular with assets under management consistently increasing every year.

Because there are now so many choices, what was once a simple and practical investing strategy is now becoming more confusing.

Keep your investment decisions in line with your overall financial objectives and the time and energy you want to devote to your investments.

Further reading in the ‘Building Your Wealth’ series:

• What You Need To Know Before Investing In Mutual Funds